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Why More Choice Can Be Bad For Investors

We’re accustomed to thinking of choice as a good thing. But behavioural economists now understand that too many options can lead people to make poor decisions—or sometimes no decision at all. In her outstanding book The Art of Choosing (Twelve, 2011), Toronto-born Sheena Iyengar shares a story about how this affects investors.

In 2000, Iyengar, a professor at Columbia Business School, published a now-famous study in which undercover researchers set up tasting booths in a grocery store. Sometimes the booths displayed six flavours of jam, while other times they displayed 24 flavours. Shoppers were 50% more likely to be drawn to the large display. However, those who visited the booth with only six flavours were 10 times more likely to buy a jar of jam.

The following year, Iyengar got a call from a researcher at Vanguard. He wanted to know why the percentage of people enrolling in employer-sponsored retirement plans was steadily declining, even as the number of fund options was on the rise. He’d read the jam study and wondered whether something similar was at work.

Iyengar and her colleagues examined Vanguard’s data and found that the highest rate of participation (75%) was among employees who had just four funds to choose from. Only 70% joined their retirement plan if they were offered a choice of 12 funds. And those who had the “privilege” of choosing from a menu of 59 funds had the lowest participation rate of all: just 60%. Iynegar suggests that employees with more choices were so overwhelmed that they put off their decision, perhaps planning to do the research later. But then they never got around to it.

More options, fewer good decisions

The problem wasn’t just inaction: many employees who did participate in their retirement plans made less than optimal decisions. Even though most of the available choices were equity funds, people with the most options were the least likely to put their money in stocks. Instead, they chose from the smaller list of bond funds, or selected the money market option. “It seems that learning about all the funds was too complicated,” Iyengar writes, “so people tried to reduce the options by pushing the largest category—stocks—to one side.”

I think of these findings as I watch the number of ETFs in the marketplace continue to grow—there are now over 200 listed on the TSX alone, and hundreds more are available from US providers. Some of the new products have been good for index investors. But for the most part, they’re more likely to confuse people who are just beginning to take control of their own finances. Faced with a dizzying number of ETF choices, they may be inclined to just stick with the overpriced, underperforming mutual funds their advisor sold them.

Don’t let this happen to you. If you’re a new investor, or if you’re considering switching to an index strategy, never forget that selecting specific ETFs or index funds is not nearly as important as choosing a suitable asset allocation and taking action now. If you don’t know where to start, see my Model Portfolios page and select the Global Couch Potato or, if your portfolio is large, the Complete Couch Potato. Get moving now, before you get distracted. It’s the most important investment choice you’ll ever make.

18 Responses to Why More Choice Can Be Bad For Investors

This is precisely why I’m so attracted to the couch potato strategy. For someone in my position, it simplifies things to a level I can understand and begin to engage in. As I engage, I learn more, and can further develop my investment strategy. It’s a fantastic entry point for a rookie investor, providing focus amidst the cacaphony of advisors’ voices, investment advertising, and product options.

I remember reading something where the author clamed that you can increase the number of choices without paralyzing consumers by organizing the choices into a hierarchy. For example, if there are 5 kinds of jam (strawberry, raspberry, etc.) and 5 brands for each kind, then poeple are able to make a decision to buy jam despite the fact that there are 25 choices. If this is true then investors would benefit from placing the growing list of ETFs into useful categories, like large cap stocks, small cap stocks, bonds, etc.

My own experience with company savings plans would have skewed any study. I’ve always had such dismal investment choices that I just put money into money market funds and pull it out periodically and invest it on my own.

Excellent post Dan B. I’d like to post a link to a nearly-year-old blog post for reference. There isn’t much to the post itself but it contains two more useful links – one to the book “The Paradox of Choice” which addresses the issues noted in some detail; and at the end to a 2009 ETF article that essentially promotes a couch potato type of strategy for ETF investors.

@Tom: Very glad to hear that you find the Couch Potato strategy liberating. I have heard from others who have said they like the idea but can’t make sense of all the ETF choices. To which I reply, “Stop worrying about the products and start focusing on the process.”

@MJ: I agree, it would be great for employer plans to suggest model asset allocations and then ask people to pick, for example, one of the the following five Canadian equity funds, one of the following five bond funds, etc. This would prevent another common problem in these plans: people pick three or four overlapping funds and think they’re diversified.

@DanH: Thanks for the great links. I love this message from your Globe piece:

“Successful indexing comes down to a few simple rules:

Minimize your costs. Aim for all-in fees of less than 0.5 per cent.

Don’t get cute with your picks. Resist the itch to attempt to outsmart the market and stick to broadly diversified funds.

If you’re unsure how to split your investments among stocks and bonds, then a good starting point is to put half into each.

Finally, rebalance only when your mix gets out of whack (say by at least 10 percentage points) to avoid making decisions driven by fear or greed.”

Quick question – I’m a new investor and I’ve started with the Global Couch Potato but I’m not sure I understand what to do when my portfolio increases to a point where I should move to the Complete Couch Potato? Do I sell the funds and change to those specific in the Complete Couch Potato or do I just add to it…..?

@Underdog: There’s no hard and fast rule here. Are you moving from index mutual funds to ETFs, or are you currently using ETFs for the Global CP? If you’re using mutual funds now, it would be easiest to just sell them all and build the new ETF portfolio from scratch. If you’re already using ETFs, then you probably already hold XIC and XBB. I’d suggest that you wait for a time when you were planning to rebalance anyway, so you can do both at the same time and save a bit on trading commissions. Either way, it won’t cost more than six trades, or about $60.

The target based funds are ideal for investors that don’t really know what to selects and if company retirement plans offer them, I think that would help adoption rates.

I can also see cash flow (can I afford to have x% of my pay redirected to investments) and type of jobs (employees in lower paying jobs less likely to invest and give up their paycheck) as impacting adoption rates.

Your article made me think about asset allocation diversification. Between my wife and I, we have 5 investment accounts (1 RRSP each, 1 TFSA each and a spousal RRSP)
Once an asset allocation is decided upon, would you recommend duplicating it in each account with the same funds/etfs or would it be wise to choose different funds/etfs within the same categories? My thinking is to keep it simple and just have 5 accounts with the same investments in exactly the same proportions. Any thoughts?

@Dave: This is a tough question. If you use mutual funds, then it doesn’t cost you any more to hold multiple funds in several accounts; if you use ETFs you may find yourself paying too much in trading commissions.

Another thing to consider is whether the accounts are for the same purpose. Presumably all three RRSPs have the same time horizon, so you can probably consider those one large account. But if your TFSAs are intended for a different, shorter-term goal, then it has to be treated separately.

Hi,
For me personally more choice can be a bad thing. As a confessed researchaholic, more choices for me definately create a state of paralysis from analysis! It took me months to put my plan in action because just when I thought I had it set, another fund would rear its ugly head for me to consider. For me there are enough difficulties involved in addressing and deciding on asset allocation. Just dont need more funds to consider.
Happy trails, Capt. Mike

@Capt. Mike: Thanks for the comment. I think this is a very common problem with enthusiastic DIY investors. I was also a tinkerer early on, and I held too many ETFs as I searched for the perfect asset allocation. I know now that it doesn’t exist.

I would definitely agree that too many choices can make investing seem overwhelming. It’s easy for people to compare a few items against the others, but when they have so many to compare they just give up and pick one that has a nice name. It’s just like grocery shopping. If there are three types of peanut butter, it’s easy to compare prices, sizes, etc. but if there are ten jars I just pick the one that is easiest to reach on the shelf.